For the last few months, I’ve been a regular reader of John Mauldin’s Weekly E-Letter and each week, John’s writing gets me thinking about important financial topics. This week is not different.

In this week’s letter, John wrote about some of the potential effects of a sustained low interest rate environment. As most folks are well aware, rates have been low for some time now, and when that happens, combined with the Fed’s stated desire to keep them low for some time yet, speculation can rum rampant.

For example, for many years investors have borrowed money in Japan and invested in the US. In Japan, where rates are low, they can borrow cheaply and then invest that money is risk assets (stocks, bonds, real estate securities) here in the US.

The net effect of this transaction, which is called a “carry trade” is that risk assets in the US rally strongly on the back of all the cheaply borrowed money. (A currency carry trade is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.)

The key aspect of a carry trade to understand is that when the currency of the country from which you’ve borrowed goes up, your profits, due to extensive use of leverage, can vaporize in a heartbeat. This is what happened in when the world hit the credit crisis last year. There was a huge demand for (safe) dollars, so all the money that was borrowed in yen was paid back and the yen was driven higher.

The same situation is now afoot in the US. It would appear that investors and funds are borrowing cheap dollars (see chart below) on a short-term basis and investing in all sorts of risk assets. Not only have stock markets risen, but so have high-yield bonds, commodities, and so on.

Look at this story from Bloomberg:

“Nov. 15 (Bloomberg) — The decline of the dollar and decisions in the U.S. not to raise interest rates have caused “huge” speculation in foreign exchange trading and seriously affected global asset prices, said Liu Mingkang, chairman of the China Banking Regulatory Commission.”

“The continuous depreciation in the dollar, and the U.S. government’s indication, that in order to resume growth and maintain public confidence, it basically won’t raise interest rates for the coming 12 to 18 months, has led to massive dollar arbitrage speculation,” he told reporters in Beijing today at the International Finance Forum.

“Liu said this has ‘seriously affected global asset prices, fuelled speculation in stock and property markets, and created new, real and insurmountable risks to the recovery of the global economy, especially emerging-market economies.’

“His view echoes that of Donald Tsang, the chief executive of Hong Kong, who said the Federal Reserve’s policy of keeping interest rates near zero is fueling a wave of speculative capital that may cause the next global crisis.”

“‘I’m scared and leaders should look out,’ Tsang said in Singapore Nov. 13. ‘America is doing exactly what Japan did last time,’ he said, adding that Japan’s zero interest rate policy contributed to the 1997 Asian financial crisis and U.S. mortgage meltdown.”

What this all boils down to is this: If world trade picks up, as it appears to be doing, demand for dollars will increase. This could result in a very strong dollar rally, which would take equity markets down worldwide, along with other risk assets. Why? Because when the currency you are borrowing in goes rocketing up, the cost to repay your loan also goes rocketing up. This is what we call a short squeeze and it is usually very painful for those being squeezed.

For a more detailed analysis, I would suggest that you read the entire newsletter.

Broken Ankles, Holidays, and Family Visits

Those who read regularly know that on Sept 5th, I had the misfortune to break both of my ankles while riding, or should I say falling off of, my dirt bike. I’m happy to report that I’m now walking again and making steady progress with my physical therapy; albeit not as fast as I’d like. Your well-wishes have been much appreciated!

This week kicks off what I consider to be the end of the year holiday season and as such, I’ve been having friends and family come down to visit me from Canada. This week and old friend came down for some time as Disneyland and Universal studios. Setting aside the challenge of walking that far in a day with sore ankles, a great time was had. My dad and brother are coming for Christmas in a month, and as we haven’t seen each other since last year, we are all looking forward to that. Hopefully, you, dear reader, will have the same good fortune!

Your comments are always welcome,
TRD